The number one question I am asked most often is, what is my business worth? It’s a question almost every business owner ponders at some time. Maybe it is in preparation to sell the business, raise capital, or just because they are curious. And most think that the formula and the answer is fairly simple, but unfortunately, it is not.
Businesses are valued in different ways depending on the purpose of the valuation. Some of these different methods include the asset method, income method, and market method.
For the purposes of this post, and our businesses, we will focus on the market method: a comparable sale method, where a valuation expert takes data from previous sales of businesses that are similar in size and quality. This method is the most accurate way to value businesses for the purpose of selling a business to a third party in the main street or lower middle market for M&A transactions.
Market Method Valuation Steps:
- The valuation expert creates a comparable sales report to help determine what multiple of earnings a business would sell for.
- This multiple is then applied to one of two earnings numbers:
- EBITDA (earnings before interest, taxes, depreciation, and amortization)
- Or, SDE (seller’s discretionary earnings)
The main difference between the two numbers is that SDE includes EBITDA plus one owner’s salary and benefits. You typically see EBITDA used in larger valuations or transactions purchased by private equity firms.
- Once you have the earnings number and the multiple from the comparable sales report, it is a simple math formula: SDE x Determined Multiple = The Value of Your Company
Sometimes the multiple shocks business owners, it is often not as high as they want or think it should be. Most companies sell for 2-6 times SDE. In fact, if you look at all business sales under $1 million for the last 10 years, the average multiple of SDE is 2.2 times.
Some clients tell us, if the multiple is only 2 times then they should just keep the company. And the truth is that if the only reason you are considering selling is for financial benefit, then yes, sometimes it is better to keep the business.
But most business owners do not sell just for financial benefit, there is another life event that is the main cause for sale: retirement, health, relocation, change of passions or desire to try something new.
Increasing Your Business Valuation
So, usually, the next question I get is, how do I increase my multiplier? The short answer: increase the value of your business. The details on how to do that is another blog post or series of blog posts all on its own!
To keep it simple, the best way to increase the valuation of a company is to focus on one of two areas: the quantity or earnings or the quality of earnings.
Quantity is straightforward, increase the amount of SDE and the valuation goes up! There are also plateaus in business valuation, the larger the SDE becomes the larger the multiple is as well. Depending on the industry, you could see multiple increases once your earnings become greater than $500,000 or $1 million.
The more intricate work comes with a focus on the quality of earnings. Buyers value certain business attributions higher than others. For example, most buyers want to be a business owner versus an operator (also known as absentee ownership). Buyers also want diversified and recurring revenue streams and stable employees. If you are able to achieve this, it can also increase the multiple of the business which increases the valuation.
Sometimes, it is not possible to increase the quantity of your earnings for whatever reason, meaning you will need to focus on the more complicated option, quality of earnings. This is the area that we focus on in our Prep to Sell program. Often, knowing where to start can be the hardest part but we can give you insight and actionable steps to take. Increasing the value of your business can be easier than you’d think.
I hope this post helped shed some light on the business valuation process and how we determine listing prices of businesses for sale. This is a complex topic and if you would like to learn more about the valuation process or how you can increase the valuation of your business, please reach out. You can also sign up for alerts for new blog posts and weekly tips on buying and selling businesses at exitfactor.com/tips. We are here to help!